Principles of Corporate Finance_ 12th Edition

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Chapter 25 Leasing 657


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lease payments. They may be right if off-balance-sheet lease obligations are moderate and
“lost in the noise” of all the firm’s other activities. But we would not expect investors, security
analysts, and debt-rating agencies to miss large hidden obligations unless they were systemati-
cally misled by management.


Leasing Affects Book Income Leasing can make the firm’s balance sheet and income
statement look better by increasing book income or decreasing book asset value, or both.
A lease that qualifies as off-balance-sheet financing affects book income in only one way:
The lease payments are an expense. If the firm buys the asset instead and borrows to finance
it, both depreciation and interest expense are deducted. Leases are usually set up so that pay-
ments in the early years are less than depreciation plus interest under the buy-and-borrow
alternative. Consequently, leasing increases book income in the early years of an asset’s life.
The book rate of return can increase even more dramatically, because the book value of assets
(the denominator in the book-rate-of-return calculation) is understated if the leased asset
never appears on the firm’s balance sheet.
Leasing’s impact on book income should in itself have no effect on firm value. In efficient
capital markets investors will look through the firm’s accounting results to the true value of
the asset and the liability incurred to finance it.


25-3 Operating Leases


Remember our discussion of equivalent annual costs in Chapter 6? We defined the equivalent
annual cost of, say, a machine as the annual rental payment sufficient to cover the present
value of all the costs of owning and operating it.
In Chapter 6’s examples, the rental payments were hypothetical—just a way of converting
a present value to an annual cost. But in the leasing business the payments are real. Suppose
you decide to lease a machine tool for one year. What will the rental payment be in a competi-
tive leasing industry? The lessor’s equivalent annual cost, of course.


Example of an Operating Lease


The boyfriend of the daughter of the CEO of Establishment Industries takes her to the senior
prom in a pearly white stretch limo. The CEO is impressed. He decides Establishment Indus-
tries ought to have one for VIP transportation. Establishment’s CFO prudently suggests a
one-year operating lease instead and approaches Acme Limolease for a quote.
Table 25.1 shows Acme’s analysis. Suppose it buys a new limo for $75,000 that it plans to
lease out for seven years (years 0 through 6). The table gives Acme’s forecasts of operating,
maintenance, and administrative costs, the latter including the costs of negotiating the lease,
keeping track of payments and paperwork, and finding a replacement lessee when Establish-
ment’s year is up. For simplicity we assume zero inflation and use a 7% real cost of capital.
We also assume that the limo will have zero salvage value at the end of year 6. The present
value of all costs, partially offset by the value of depreciation tax shields,^9 is $98,150. Now,
how much does Acme have to charge to break even?
Acme can afford to buy and lease out the limo only if the rental payments forecasted over
six years have a present value of at least $98,150. The problem, then, is to calculate a six-year


(^9) The depreciation tax shields are safe cash flows if the tax rate does not change and Acme is sure to pay taxes. If 7% is the right dis-
count rate for the other flows in Table 25.1, the depreciation tax shields deserve a lower rate. A more refined analysis would discount
safe depreciation tax shields at an after-tax borrowing or lending rate. See the Appendix to Chapter 19 or the next section of this
chapter.

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